A critical analysis of the causalities of the sub–prime crisis
A trend emerges when comparing the way economic crises of all types over the past century were created. In the past century economic crises have all been the result of financial market booms that occurred in environments of low inflation, low interest rates and rising real GDP growth. A boom in financial markets can lead to the existence of a bubble characterized by asset prices rising independently from their fundamentals. As these booms progress, inflationary pressure builds up and central banks inevitably tighten policy interest rates. Booms inevitably lead to a state of over indebtedness, as agents find themselves unable to service their liabilities due to insufficient cash flow. This opens the door for a crisis situation as market participants start to pull back and as they do, they take with them the liquidity needed to keep financial markets efficient. Economic crises of all types can lead to declining net worth’s, bank failures, bankruptcies and an ensuing recession. The recurrence rate of banking sector problems leading to bank insolvencies and economic crises have increased in recent decades. The study indicated that the sub–prime crisis follow the same pattern as all other historic economic crises and is, therefore, no different than previous economic crises. There might not be a recurrence of the exact events that have led to the sub–prime crisis, but since all major economic crises over the past century follow the same pattern the likelihood of history repeating itself is not farfetched. The overall aim of the study was to identify the causalities of the sub–prime crisis in order to propose policy recommendations on how to avoid a recurrence of such banking crisis in the future. Future action to avoid the same mistakes made in the sub–prime crisis can only be taken once there is a clear understanding of what actions, taken by which parties, caused the creation of a mortgage bubble. The dissertation consisted of a literature study on the causalities of the sub–prime crisis and paid specific attention to various parties, policies, processes and events in the United States of America that created the sub–prime crisis. Although various parties played an influential role in creating the sub–prime crisis, the conclusion withdrawn from the study was that the sub–prime crisis was a mortgage bubble boom, and a crash, created predominantly by the Federal Reserve Bank of America. An expansive monetary policy was implemented by the Federal Reserve Bank of America in reaction to financial turbulence in the aftermath of the dot–com crisis and the September 11 terrorist attack on the World Trade Centre. The expansive monetary policy implemented by the Federal Reserve Bank of America was one of the biggest contributing factors to the subprime crisis. The sub–prime crisis was the latest economic crisis in a long line of economic crises, all of which developed during prolonged periods of expansive monetary policy. The study found no evidence supporting any other similarities between the various economic crises experienced over the past century. Therefore, the conclusion withdrawn from the study was that central banks have been fostering conditions for financial market booms through the implementation of an expansive monetary policy. It is, therefore, vital to the stability of financial markets and the global economy that more care should be taken when controlling inflation through the expansion and contraction of the money supply.